Thursday, January 7, 2016

Macro: The Chinese New Year

The gyrating market this week so far has more than done its bit to jolt people out of their holiday stupor. The Chinese equity markets and the law makers kept everyone, well, engaged. Late this afternoon we have seen some respite after the Chinese authorities repelled the stock circuit breaker rules. Equities rallied from day's low and bonds sold off. All fine and good. The question is, is it time to fade the market full of confused and panicked investors? Or should you panic yourself instead.
Whether the Chinese episode is something to worry about depends on the opinion about how in control the Chinese policy makers are, and what is their line of thinking. Chinese Yuan devaluation is not necessarily such a risk-off thing in itself. Arguably the Chinese authority looks at CNY against a trade-weighted baskets and not only dollars. And also in terms real effective exchange rates, Yuan is far from cheap, and a bit of regression to the mean (at whatever the authorities think it should be) should not cause so much pandemonium. Then again, it is not clear how much control the authorities have in executing these changes. Last year, and this year so far, most of the Yuan "devaluation" has been rather abrupt. This may be the communication policy of PBoC. But apparently that did not go well with the market. The re-balancing problem in China is a real thing. And it is just that, a re-balancing problem. If it can be controlled, with controlled devaluation and a smooth transition from investment based to consumption based GDP, and most importantly manage the debt from blowing off in between, this will be an adjustment.
If it is not controlled, it will be a crisis. Some are already calling it so. I tend to think it is not. Referring to someone who knows more about China than perhaps anyone else, there are encouraging signs in this rebalancing effort. The Chinese foreign exchange reserve is a hot issue in near terms. But more importantly, it is how they maintain the balance in the economy (low enough unemployment and no mass-bankruptcies) before they adjust to the new GDP paradigm is the most important question. And FX devaluation is a pretty smart and cheap way to achieve that. At a milder cost of a negative pressure on global inflation. Unless that creates a panic and becomes a self-fulfilling crisis.
Market seems to be focused on the second point of FX devaluation, fed by researches on where the level official reserve is and how much outflow it has seen in recent time. Remember how the Chinese market sold off massively in the June and rest of the world hardly noticed? And when that reversed in August when the PBoC revised CNY fixings. The question is how justified this fixation on FX is. The political economy in China is pretty much different than the developed nation or what we have seen in case of the Asian tigers or LatAms under sudden stop, The authorities, in principle, has much wider control on the economy. And if they do succumb to the sudden stop problem and that blows in to a full scale crisis with a collapse of asset prices, it will be felt far more geopolitically, than economically (apart from a certain global deflation, again). I would tend to assume so far what we have seen from the policy-makers are more likely to be mistakes and experiments than a sign of loss of control.
In the meanwhile, coming back to the original question, should to panic or fade? Statistically speaking, the odds are something like below (click to enlarge).

The charts shows the conditional upside and downside in representative equities after a given amount of weekly sell-off (the opportunity is the difference between upside and downside). It captures the next week's percentage move (vertical axis) given a percentage sell-off this week (x-axis). As we can see, with extreme moves come extreme opportunities. Equities so far sold off around 4% to 5% this week across markets. As you can see the time to jump in to wanton bullishness is still a couple of percentage points away, statistically speaking.
Note: these data sets excludes the wild days of 2008, but including them does not change the picture much.

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